Recently, investors in Chinese companies listed on U.S. stock exchanges that are suspected of fraud, as well as U.S. accounting firms that audit those companies, have been unable to obtain audits performed in China by Chinese accountants acting on behalf of the U.S. firms, perhaps because of a Chinese law forbidding disclosure of “state secrets.”

U.S. and Chinese regulators have so far been unable to agree on how review of those audits should be conducted, but this stalemate needs to be resolved. Sovereignty should not be used as a cover for inadequate financial transparency.

The dispute stems from the fact that American auditing companies cannot open their own auditing offices in China and must operate through Chinese affiliates. The Chinese government has long rejected American requests to investigate Chinese auditing companies on the grounds of protecting Chinese sovereignty. The American accounting firm Deloitte Touche Tohmatsu is “caught in the middle of conflicting demands by two government regulators,” according to a company spokesman. The U.S. Securities and Exchange Commission (SEC), investigating fraud by a Chinese company listed on the New York Stock Exchange, has demanded that Deloitte produce audits by Deloitte’s Shanghai affiliate. Deloitte has refused to comply with the SEC demand (now the subject of a subpoena from a Federal court) because it fears punishment under Chinese secrecy laws.

Deloitte’s China-based unit had been the auditors of Longtop Financial Technologies, Ltd, which listed on the New York Stock Exchange in 2007 for $17.50 a share. The SEC’s scrutiny of Longtop began after Deloitte expressed concern about whether the company’s cash balances had been correctly reported to Deloitte’s affiliate in China. Deloitte “smelled trouble” and resigned as Longtop’s auditor following threats and intervention by the company when Deloitte’s affiliate tried to confirm Longtop’s cash balances at local banks. The SEC subsequently delisted Longtop and subpoenaed papers from the accounting firm’s audit of Longtop.

In explaining its refusal to comply with the subpoena, Deloitte argued that “turning over [its Shanghai affiliate’s] work papers could violate Chinese law prohibiting the disclosure of ‘state secrets,’ which it says includes information about the ‘national economy and social development.’ ’’ The SEC, in a court filing seeking enforcement of its subpoena of the audit, reported that Deloitte had approached the China Securities Regulatory Commission (regulator of Deloitte’s China unit) as well as three other Chinese agencies seeking permission to transfer the documents, but none replied.

Negotiations between Chinese government regulators and the Public Company Accounting Oversight Board (PCAOB) based in Washington, D.C. began last year. The PCAOB is a non-profit corporation that was created by the 2002 Sarbanes-Oxley law to oversee the audits of public companies in order to protect investors in the wake of high-profile accounting scandals such as WorldCom and Enron.

In addition to the Deloitte-Longtop case, there are other problematic cross-border accounting cases that involve Chinese companies accused of fraud that were able to obtain U.S. listings without undergoing the due diligence that is performed by an underwriter of an IPO. Instead, Chinese companies have used a perfectly legal means known as a “reverse takeover” (RTO) or “reverse merger” which occurs when an unlisted company purchases a majority of shares in an inactive company that is already listed on a U.S. stock exchange.

The RTO route, as The Wall Street Journal noted, allowed companies to start trading without a formal underwriting process or SEC review of the prospectus, and many of those companies used tiny U.S. audit firms that appeared to do very little work. The consequences of this gap in U.S. securities regulation are by now apparent, with more than two dozen Chinese companies listed through reverse mergers having announced auditor resignations or other accounting problems as of July 2011.

Since the RTO problems surfaced, the SEC has approved more rigorous rules: Reverse merger companies cannot be listed unless they have filed audited financial statements covering a full fiscal year commencing after the filing of specified initial documentation.

But while the RTO rules have changed, troubling questions remain. How can American accounting firms adequately confirm the accuracy of their affiliates’ audits if they are denied access to accounting information on listed Chinese companies that may have engaged in fraudulent conduct? In November, 2011 a report appeared that Chinese officials had met with “representatives of the top worldwide accounting firms to warn them about releasing information to outside parties as a possible violation of Chinese secrecy laws.”

Are state secrets really involved? The SEC, in its request to a Federal court to force Deloitte to hand over audit papers, argued “it is entirely unclear what national interests of China are truly at stake.” Although Chinese law is vague, an amendment to the State Secrets Law promulgated in April 2010 provided that only commercial information from “central enterprises” — 120 state-owned companies under the jurisdiction of the State Assets Supervision and Administration (SASAC) — could be considered “state secrets.” Some transactions of audited companies with such “central enterprises” could be classified as “state secrets,” but so far there has been no hint of this in the cases mentioned here.

Another issue underlies these cases: The PCAOB evaluates the firms that audit the books of companies traded in the U.S., and for that reason has been trying for some time to gain access to the audits performed by some 50 auditing Chinese companies. The PCAOB has requested that it be permitted to conduct joint inspections with Chinese regulators but this has been rejected so far. A dialogue with Chinese regulators last summer ended without agreement. Another meeting was scheduled for the fall, but the Chinese canceled. The President of the PCAOB has recently announced that another meeting will be held soon.

These problems need quick resolution, and the U.S. should push forcefully for it. U.S. investors, who are sought by Chinese firms, need sufficient evidence of the soundness of those firms, while the Chinese government wants companies to be able to obtain foreign financing. It is reasonable for the U.S. to support requests for adequate information in order to protect American investors.

Chinese national sovereignty would not be violated if China permits American regulators within its boundaries solely in order to inspect the finances of U.S.-listed Chinese companies. A hard economic reality may underlie China’s resistance to foreign inspection of Chinese audits: Rather than uncovering any “state secrets” protected by Chinese law, thorough inquiries could disclose embarrassing flaws in Chinese financial and auditing practices. But continuing to shield companies from the consequences will only deepen investor mistrust even as China’s presence expands in global markets.

Stanley Lubman, a long-time specialist on Chinese law, is a Distinguished Lecturer in Residence at the University of California, Berkeley, School of Law and is the author of “Bird in a Cage: Legal Reform in China After Mao,” (Stanford University Press, 1999).

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